Pay Debt with IRA Money?

The holidays are over, reality has returned, and maybe now you’re struggling with high-interest debt. Thinking about tapping your IRA? Everybody’s situation is different, but in general my thought is this: Please don’t, especially if you’re 59 or younger.

Penalty Box

If you withdraw money early (before age 59-1/2) from a tax-deferred retirement account, you’ll owe the IRS income tax on the amount withdrawn at your normal marginal income tax rate PLUS—unless the money’s for an “allowed purpose“—a 10 percentage point penalty. So if your normal marginal income tax rate were 15%, you’d pay 25% tax (15% + 10% penalty) on money withdrawn early from a tax-deferred retirement account.

Say you’re thinking of withdrawing money from a traditional IRA account to pay off $20,000 in credit card debt. To be sure you’ve got the money to pay the big tax bill on your withdrawal when April 15, 2013 rolls around, you’d have to withdraw from your IRA $26,667 (if you’re in the 15% income tax bracket). Why? Because that’s how much you’d need to withdraw to have $20,000 for the credit card companies and still set aside what you’d need to pay the income tax + penalty of 25%. And a plan to pay the IRS is crucial; a debt to Uncle Sam is almost impossible to escape from—short of death or becoming a Big Banker.

The high-interest debt trap is a huge challenge, no doubt. But there are better ways to tackle it besides an early withdrawal from an IRA.

Besides the tax penalty, though it may not seem like it now, you will retire someday. When you do, you’ll need money to live, and unless you aspire to tent-living or perhaps sharing a home in your senior years with a resentful son-in-law & family, Social Security alone won’t be enough. You need to save money, and a lot of it, to live comfortably through your elder years. An IRA is one of the best ways to sock away the cash you‘ll need.

Here’s the next thing: If you’re in this bind because you put the holidays on a credit card, consider a plan to do better in 2012. As part of your overall budget planning, decide how much extra you want to spend this December. Then put 1/12th of that aside in a special savings account every month in 2012. When the holidays arrive, use the money, and tell Mr. MasterCard to kiss off!